Bank Stocks Are About to Get Much More Attractive

by Tim Melvin | March 26, 2014 8:50 am

The Fed has finished up the latest round of stress tests for the 30 largest banks in the United States. They tested how banks would fare in a severe economic downturn and how much capital would be lost.

What did they learn … and more important, how could it affect investing in bank stocks?

The Fed set up a nightmare scenario that included a 50% decline in bank stock prices, an 11.25% unemployment rate and a 25% decline in housing prices. Under this nightmarish scenario 20 of the 30 banks passed — and the simulations show that they could retain enough capital to survive without a bailout. Only Zions Bancorp (ZION[1]) failed the test.

Wells Fargo (WFC[2]) has said that their internal testing showed that they would do much better than the Fed projections. Management at Wells believes that in the horrid scenario their total losses would be “just” $26.8 billion, and not the $55.1 billion the Fed projects.

It is unlikely that the Fed will change their numbers and will base their decision on allowing Wells’ capital plan on their numbers, and not the bank’s more optimistic assumptions. In fact they may question banks whose internal numbers are markedly different as to their methodologies. The Fed will announce today which banks will be able to proceed with their capital plans regarding dividends and share buybacks. In addition to the stress test results, regulators will also consider qualitative factors such as corporate governance and potential legal issues faced by the banks.

In spite of the difference of opinion, Wells passed the test with flying colors. I believe the bank will get approval to raise the dividend payout, possibly to record levels.

Bank of America (BAC[3]) did not fare as well as it had hoped. The bank’s internal test showed the bank weathering the storm with a Tier 1 capital ratio of over 8.5%, while the Fed results showed it at just 6% in a sustained downturn. This result could hurt the bank’s chances of getting its capital plan approved — and a failure there might weigh on the shares. Investors are hoping that the bank will substantially hike its current $0.01-a-share quarterly payout to as much as $0.05 and increase the pace of its share buyback. BAC was turned down back in 2011 and has not asked for an increase in the dividend rate since.

JPMorgan (JPM[4]) may have the biggest battle with qualitative issues among the big banks. The bank has had problems with lawsuits over the mortgage mess, management controls and money-laundering problems. The bank has said that it has significant excess capital and would like to use it to provide a substantial dividend increase right away … with the potential to grow by a penny or two every quarter.

Given the fact that almost all of the banks passed the stress test I believe we’ll see a round of dividend hikes and increased buyback programs from many banks. There is a total of $75 billion of excess capital at these banks — and much of it could find its way back into shareholder pockets.

At the time of publication, Melvin had no positions in the bank stocks mentioned.